Buybacks: A Wolf In Sheep's Clothing

Buybacks are supposed to make us feel all warm and fluffy about companies. "See?" we are supposed to think. "Management believes in the stock." But why are the companies doing these buybacks underperforming the market?

The chart below compares the PowerShares Buyback Achievers ETF (NASDAQ:PKW) (in blue) with the S&P 500 (red) and Nasdaq Composite (green), since the launch of PKW in December 2006. PKW holds the stocks of companies engaged in large-scale corporate buybacks. So far, it is trailing the S&P 500 by more than 5% since inception, and the Nasdaq Composite by more than 10%.

I’m not picking on PowerShares' fund specifically. The idea that stocks engaged in corporate buybacks do well is one of those old investment truisms, and it’s no surprise that there is an ETF today tied to the concept.

Instead, I think the driving force behind corporate buybacks has changed... and the impact of buybacks on the market has changed as well.

In the good old days, companies did buybacks mostly in extraordinary circumstances, like when the stock fell excessively in reaction to relatively minor news. Now, however, buybacks are almost a line item in corporate budgets. X dollars for salaries, Y dollars for office supplies and Z dollars for corporate buybacks.

And that’s bad news for shareholders. Why? For one, buybacks are used to cover up costly options schemes that would otherwise dilute the company’s stock. It’s a neat trick to report profits and then use those profits to cover the real expense of an options program.

But just as importantly, as I've written before, buybacks favor management over current shareholders. Corporations have two choices on how to return money to shareholders. They can pay it out as dividends to current shareholders, or they can buy back stock. The problem with buybacks is that they raise the value of both existing shares and shares that have yet to be issued, aka options. Buying back stock today increases the value of the options that executives will cash in tomorrow. And faced with the option of choosing buybacks vs. dividends, not surprisingly, most corporate officers are choosing buybacks.

The S&P 500 set a new record for buybacks in the second quarter, with companies spending $158 billion. Over the past three years, S&P 500 companies have spent over $1.1 trillion repurchasing stock. To put that in perspective, the entire market capitalization of the S&P 500 is just $14 trillion.

Over the same time frame, S&P 500 companies have paid out just $594 billion in dividends - less than half of the stock buyback budget. In fact, the S&P says that the situation is getting worse: the number of companies that raised their dividends in Q3 fell sharply from Q2.

"Standard & Poor's believes that the explosion in corporate buyback activity is the primary contributor to the slower pace in dividend growth," said Howard Silverblatt, senior index analyst at Standard & Poor's.

Maybe investors will take a look at the buyback ETF and realize that, in today’s market, buybacks aren’t necessarily such a great thing. I know I have.